Portfolio Manager Nick Schommer discusses the importance of understanding a company’s business model to assess value and risk in an investment.

Key Takeaways

• While valuation is clearly an important factor in assessing an investment, we think focusing on the quality and durability of a company’s business model is perhaps even more critical in the current environment.
• Amid the pandemic, some companies that may appear attractive on a valuation basis have significantly disrupted business models, creating the potential for permanent loss of capital.
• Moving forward, we think identifying business model advantages across the market will be important, particularly as the economic recovery broadens outside of narrow, mega-cap tech leadership.

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Nick Schommer: So thinking about the difference between having a valuation focus and being a value investor, we always talk about being business model investors first and then putting a valuation lens on it second. I think this is an important difference. When we think about where capital appreciation comes from over time, it’s from not only the re-rating that hopefully the market puts on a stock, but it’s from the compounding growth of that business. It’s obviously important to buy a stock at a fair or a discount to what we believe it’s worth, but it’s not more or less important than focusing on the business model.

When we think about value funds or value factor investing, that’s very much based on a price-to-book measure, a price-to-earnings measure, and doesn’t consider the quality or the durability of the business. And unfortunately in a period where we’re seeing great disruption in the economy as this digital transformation takes place, a lot of those businesses, or a lot of those stocks that screen well on a value factor are on the wrong side of their disruption. And increasingly, the terminal value the market is willing to pay for those companies is going down. So that’s how we think about value investing or value … having a valuation focus versus being a value investor.

The second aspect of why we start with the business model first is not only because of the compounding growth, and we want to capture that over time, but it’s because of our view of risk. And we view risk as the permanent loss of capital. And we touched on that, with such a high level of disruption taking place in the economy, this is increasingly taking place where businesses like oil and gas exploration companies or brick and mortar retailers are really seeing permanent loss of capital because their businesses are going away or they’re having to dilute themselves substantially during this period of disruption in this global pandemic. As we look forward, we think this will continue to be true. A lot of the digital trends and transformation that’s taking place in society will continue for a number of years going forward. These underlying secular trends that are taking place in the economy are going to continue to persist and that’s why we think it’s important to continue to focus on the business model in addition to having a valuation focus.

Looking forward to 2021, which I think, at this point we’re all excited to turn the calendar, I think the trends that we began to see in the fourth quarter, with a broadening of the market as the market started to look forward to a return to normal, is what we’re going to see in 2021. So where a small portion of the market drove most of the returns in 2020, particularly the mega-cap tech stocks that were the beneficiaries of a stay-at-home work environment, in 2021, we should see a broadening to small- and mid-cap stocks, cyclical stocks, as global GDP growth is set to accelerate substantially, really coming out of a sharp drawdown. As we shut down the economy in 2020, we should see a very strong snapback in 2021, particularly in the second half of the year as the consumer is comfortable with the health situation, plus receiving their vaccine, and there’s going to be substantial pent-up demand for travel and other activities that the consumer was unable to enjoy during the lockdown periods.